Scarcity Through Zoning

The Real Estate Espresso Podcast

Scarcity Through Zoning

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Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. On today’s show, we’re talking about scarcity through zoning.

I often have discussions with investors about whether things should be easy or not. Well, if it’s easy, anyone can do it, the barrier to entry’s low and eventually, the market will become saturated, just like adding an additional vehicle to the Uber fleet. The barrier to entry is almost zero.

We see this regularly in cities like Houston where there are no zoning restrictions. That means you can put anything anywhere, and people do. For the most part, the market forces seem to take care of things and common sense generally prevails. But, if you wanted to put a daycare next to an old refinery, you could. If you wanted to build a strip club next to a church, you could. The good news is that you face very few regulatory barriers. That makes it easy, or at least easier.

As long as the Municipal Utilities District has the capacity and commits to serve your property, you can build. As long as your design meets the requirements of the fire marshal and the building code, you can build. The good news is, it’s easy. But the bad news is, it’s easy.

We’ve seen numerous cycles where, as a result of growth and projected growth, the Houston market has become oversupplied in several different asset classes. The other end of the spectrum is where land use is restricted with zoning in the city’s master plan. This can and often does create shortages of certain land uses, which can drive up the value. That barrier to entry makes it hard. Getting a property rezoned is possible sometimes, but rezoning carries considerable risk. You might not get approved even if you think your concept makes a lot of sense. In that case, the barrier to entry could be very high, and high prices sometimes make no sense.

We’ve all seen cases where high macro prices don’t seem to make any rational sense, but high prices can also be indicative of high demand and a shortage of supply, and it’s that high demand that provides a bit of a safety net for your investment. If it became easy all of a sudden, there could be some impact on the market. These things happen slowly.

We’ve seen examples where some cities have eliminated the R1 residential zoning. That has thrown the field wide open for multi-family construction in areas that were previously zoned for detached single-family homes. But even in those cases, the new supply for multi-family applications has been slow to materialize.

Let’s look at two case studies. A study on Minneapolis found that after its 2019 zoning change there was a reduction in single-family permits, but no conclusive, immediate difference in total or multi-family units permitted in the short to intermediate term. And that’s measuring from 2016 all the way through 2021. That suggests the policy’s full effect on housing supply is probably going to take a decade or more to materialize.

Another example is California’s SB-9. That law allows for property owners in single-family zones to split their lots to four units. They’ve had very limited uptake initially. As of December of last year, one report noted that only 660 SB-9 applications have been submitted statewide, with only 25 projects reaching completion. That indicates that while the legal barriers were removed, other factors like high construction costs, other bureaucratic hurdles, and the complexity of developing the missing middle housing is still a slow process.

When SB-9 was implemented, the Turner Center estimated the new legislation would enable about 700,000 new units to be built, especially in high population cities like Los Angeles, but clearly the barrier to new supply is more than just zoning. In cities where there’s been a lot of missing middle product, there is a shortage of developers who have the capacity or interest to invest in that product type. Smaller buildings tend to be hyper local in nature, and they are too small to attract institutional capital. They’re too small to effectively manage, unless you can build a cluster of properties that could be aggregated together.

I personally have been involved in the design and construction of these types of buildings in Philadelphia, where we use land assemblies within the confines of the zoning to build allowed density, subject to the existing 38-ft. height restriction. In some cases, the buildings were 9 units, or 11 units, or 13, or 4, or 10, it simply depended on what we could build in residential multi-family zoning. But by building enough within a few blocks radius, we could effectively manage the portfolio as if it was a monolithic building.

The opportunity really lies in overcoming the scarcity of land and adding to the supply for those product types where there is excess demand. Some areas are vastly underserved with industrial product… We have seen many cases nationwide where communities have rezoned land that was originally zoned industrial to make way for residential. In many of those communities, there is a significant shortage…

That barrier represents an opportunity to fulfill demand, while maintaining a barrier for new entrants to come into the market behind you. After all, warehouses do not vote, so it is more difficult to get land zoned for industrial uses. And therein lies the root of the shortage… So, in that case, the bad news is that it is difficult, and the good news is that it is difficult.

As you think about that, have an awesome rest of your day. Go make some great things happen. And we’ll talk to you again tomorrow.

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